Pairs Trading Strategy Explained
Pairs trading happens when traders try to take advantage of the statistical relationship between two similar stocks. The traders believe they can trade the stocks and make a low-risk profit. This, of course, only happens if the statistical relationship stays as it did in the past.
What is Pairs Trading?
Pairs trading involves trading two stocks that have a high correlation. When two stocks have a high correlation, they experience almost the same ups and downs at the same time. If the correlation is reliable enough, pairs traders may try to exploit the rare times they move away from each other.
Perfect correlation means the stocks move in tandem 100% of the time or a correlation of one. A high correlation means less than perfect correlation. For instance, if two stocks have a correlation of .90, they might move together around 90% of the time. This might be what pairs traders are looking for.
An opportunity for a pairs trade may come during the rare time when the stocks move away from each other. The trader will take advantage during this time in hopes that the two stocks will move together again.
Pairs Trading Strategy
A pairs trade involves a long and short position in two highly correlated stocks. When you short a stock, you profit when it goes down. A traditional long position profits when the stock goes up.
During the rare time when two stocks with high correlation move away from each other, one goes up, and the other goes down. The pairs trader will take a short position in the stock that went up and a long position in the stock that went down. The two positions are of equal dollar amounts.
The pairs trader hopes that the two stocks will soon reverse and begin to move together again. When the two stocks reverse, the short position in the stock that had gone up will profit when the stock goes back down. In addition, the long position in the stock that had gone down will benefit when the stock goes back up. If all goes according to plan, the pairs trader will close both positions with a profit in each position.
Pairs Trade Example
Say Stock A and Stock B are both $100 and have a high correlation. Because the correlation is not perfect, sometimes the two stocks do not move in the same direction. If you notice that Stock A has moved down to $90 and Stock B has moved up to $110, you may have a chance for a pairs trade.
Since the two stocks have been highly correlated in the past, they may begin trading in the same direction soon. In this example, you would take a long position in Stock A and a short position in Stock B in the same dollar amount.
You will make a quick profit if the two stocks return to $100. For example, if your long position in Stock A at $90 returns to $100, you’ll profit $10 for each share you bought. In addition, if your short position in Stock B at $110 also returns to $100, you’ll receive an additional $10 for every share that you shorted.
On the other hand, the stocks could move in the same direction again. Say both stocks have increased by $10. Your long position in Stock A at $90 will profit $10 for each share. On the other side of the trade, your short position in Stock B will also gain $10, and you’ll lose $10 per share. In other words, the profits and losses cancel each other out, and the pairs trade was a wash.
Pairs traders view the strategy as a good risk and reward trade because you can make a profit, but you won’t lose money. This view may not be entirely accurate because pairs trades may have more risks than you think.
Pairs Trading relies on correlation, which is a form of technical analysis. Technical analysis hopes that trends in the past will repeat in the future. Readers probably know that past performance does not guarantee future results.
That tenet is true for technical analysis also. For instance, just because two stocks have been highly correlated in the past does not guarantee that they will continue to be highly correlated in the future. That means that both the long and short positions in a pairs trade can, in fact, lose money.
There are also additional risks to short positions. Short positions require a margin account. Brokers need a margin account because stocks can, theoretically, rise forever. Though stocks can’t really go up forever, they can rise dramatically very quickly. If that happens, your losses could exceed the amount you have in your account.
In most cases, if a short position loses a predetermined amount of money, the broker could force you to close the position or add more money to your account to cover your losses.
About BJ Cook
BJ Cook is a long-time stock nerd. He has held several roles in the equity research world and earned the right to use the CFA designation in 2014. When he’s not writing for Investment U, you can find him searching for new investment ideas. Outside the investment community, BJ is a die-hard Cubs fan.